Federal Communications LawJournal

Volume 51 | Issue 1 Article 6

12-1998

State Sales & Use Tax on Internet TransactionsSandi OwenIndiana University School of Law

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Part of the Communications Law Commons, Constitutional Law Commons, Internet LawCommons, and the Taxation-State and Local Commons

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Recommended CitationOwen, Sandi (1998) "State Sales & Use Tax on Internet Transactions," Federal Communications Law Journal: Vol. 51: Iss. 1, Article 6.Available at: http://www.repository.law.indiana.edu/fclj/vol51/iss1/6

NOTE

State Sales & Use Tax on InternetTransactions

Sandi Owen*

I. INTRODUCTION ............................................................................. 246II. OVERVIEW .................................................................................... 247

A. Traditional Sales and Use Tax Structure .............................. 247B. Shift to Electronic Commerce ............................................... 248C. Lack of Fit Between Old Sales Tax System and New Elec

tronic Commerce ................................................................... 250Ill. CHALLENGES AND CONCERNS ...................................................... 251

A. Concerns of State and Local Taxing Authorities vs. Busi-nesses and Consumers .......................................................... 251

B. Compliance Challenge ........................................................... 253C. Collection Concerns .............................................................. 253D. Need for Predictability .......................................................... 254

IV. SUPREME COURT GUIDANCE ON THE NEXUS ISSUE ..................... 255A. Constitutional Issues .............................................................. 255B. M ail-Order Cases .................................................................. 255C. Similarities Between Mail-Order and Telephone-Order

Sales and Internet Sales ......................................................... 257V. APPROACH TO A POSSIBLE SOLUTION .......................................... 258

A. General Guiding Principles ................................................... 2581. Economic Neutrality ....................................................... 258

* B.S., Brescia College, 1984; M.B.A., University of Kentucky, 1986; candidate forMPA in Taxation, Indiana University Kelley School of Business; candidate for J.D., Indi-ana University School of Law-Bloomington, 1999.

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2. U niform ity ....................................................................... 2593. Adm inistrability .............................................................. 259

B. National Focus ...................................................................... 259C. Redefining Nexus ................................................................... 260

V I. CONCLUSION ................................................................................. 262

I. INTRODUCTION

With the explosive growth of electronic commerce, the way peopledo business is dramatically changing. More and more transactions are be-ing conducted electronically, and the geographic boundaries that onceplayed such a significant role in commerce are rapidly disappearing. Withthis growth and globalization of electronic commerce, state and local tax-ing authorities have become concerned that the information superhighwaybypasses state and local taxation. Since sales and use taxes on transactionsare major sources of revenue for state and local governments, erosion ofthis tax base has serious repercussions for their ability to support local in-frastructures. Industry interests, however, express concern that taxation ofInternet transactions, both from a financial and administrative perspective,would discourage innovation and investment in the information super-highway and impede its growth.

This Note argues that the existing structure for taxation of physicalcommerce does not fit the developing reality of an electronic commerce-based economy. The traditional means of taxing the sale of goods andservices is based on concepts of physical assets, geographic locations, andface-to-face encounters. Commerce on the Internet is based on technologywhere there is no locality, no physical presence, and no geographicboundaries. Since Internet transactions do not fit into the traditional physi-cal commerce tax structure, new standards for defining when and how ataxing jurisdiction may tax an Internet transaction must be developed.

Internet transactions have virtually eliminated the geographicboundaries between states and localities that formerly provided the frame-work for sales and use taxation. As a result, a national tax policy must bedeveloped either through uniform state laws or federal legislation. Anyfederal legislation or uniform state laws developed to regulate interstateelectronic commerce must balance the needs and concerns of state and lo-cal taxing authorities with the needs of businesses and consumers. Thisbalance must occur within the framework of basic tax principles of fair-ness and equality and minimization of administrative and compliance bur-dens.

Although the taxation of electronic commerce raises issues in severaltax areas, including international taxes, federal income taxes, and state and

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local property taxes, the focus of this Note is on state and local sales anduse taxes. The Internet transactions that are discussed are the sale of goodsand services over the Internet, with either physical or on-line delivery tothe purchaser from the vendor. This Note does not discuss sales and usetax issues relating to other Internet transactions, such as the sale of Internetaccess services, Web space, or Web page advertising.

Part II of this Note provides an overview of the traditional sales anduse tax structure and discusses why modem electronic commerce does notfit into this traditional structure. Part I discusses some of the challengesof taxation of electronic commerce and the concerns of state and localtaxing authorities versus those of businesses and consumers. Part IV pro-vides a review of what guidance is currently available and the constitu-tional considerations in the taxation of Internet transactions. Part V pro-poses a national approach, through federal legislation or uniform statelaws, to the sales taxation of Internet transactions and offers recommenda-tions, such as a shift of focus from the seller's to the buyer's location, foraddressing the taxing challenges of doing business in cyberspace.

II. OVERVIEW

A. Traditional Sales and Use Tax Structure

The typical sales tax structure of a state involves a retail sales tax im-posed on tangible personal property purchased in the state.' A state mayalso impose a use tax on its residents for tangible personal property ac-quired in another state but used in their resident state.2 Sales and use taxesare typically imposed on purchases by the final consumer, and transactionsbetween businesses are exempt! The sales tax has been referred to as a"tax on the freedom of purchase[,]" whereas the use tax is a "tax on theenjoyment of that which was purchased."4

Three factors determine whether sales or use tax liability in a par-ticular state exists for a transaction: (1) the type of good being sold, (2)situs, or the location where the transaction takes place, and (3) nexus5

Traditionally, sales tax has been imposed on tangible goods, not on intan-gible goods or most services, and is assessed and collected at the location

1. See generally 2 JEROME R. HELLERSTFiN & WALTER HELLERsTEiN, STATETAxATION: SALES AND USE, PERSONAL INCOME, AND DEATH AND GIFt TAXES (1992).

2. Id.3. Id.4. McLeod v. Dilworth Co., 322 U.S. 327,330 (1944).5. Sally Adams, Danger: Internet Taxes Ahead, TAXES, Sept. 1997, at 495, 501.

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where the good is transferred from the seller to the buyer (the situs). 6 Theconcept of nexus concerns whether the taxing jurisdiction has sufficientconnection to have the authority to impose taxes on the transaction andcollection responsibility on the vendor.7 Each of these factors will be ex-plored within the context of the Internet, as opposed to traditional physical,retail transactions.

B. Shift to Electronic Commerce

Electronic commerce is defined as "'the ability to perform transac-tions involving the exchange of goods or services between two or moreparties using electronic tools and techniques."' 8 Examples of electroniccommerce include on-line catalogs for ordering goods, computer softwarethat can be downloaded, and on-line information, such as LEXIS or West-Law electronic databases.9 Some of the primary growth areas for consumerpurchases over the Internet are airline tickets, computer hardware andsoftware, and books, music, and entertainment.'o

In 1997, approximately "100 million people logged onto the Internet,up from 40 million the year before."" A recent Forrester Research, Inc.study projects that "electronic commerce will reach about $350 billion by2002, from an estimated $22 billion this year."' 2 Approximately "80% ofbusiness on the Net today is conducted between companies," with the re-maining 20 percent involving direct sales to consumers. 3 The Forresterstudy estimates that "[n]early one-third of online households made a Netpurchase [in the first six months of 1998], up 50% from [1997]," and that"It]hose who didn't buy online used the Net to help make a purchase deci-sion."'

14

The shift from physical commerce to electronic commerce hasbrought about changes in the way businesses market, package, and distrib-

6. HELLERSTEIN & HELLERSTEIN, supra note 1, 12.03, at 12-8 to 12-9.7. Walter Hellerstein, State Taxation of Electronic Commerce: Preliminary Thoughts

on Model Uniform Legislation, 12 STATE TAX NoTEs 1315, 1318 (1997) [hereinafterHellerstein, State Taxation: Preliminary Thoughts].

8. Walter Hellerstein, Telecommunications and Electronic Commerce: Overview andAppraisal, 12 STATE TAX NoTEs 519, 520 (1997) [hereinafter Hellerstein, Telecommunica-tions].

9. Id.10. Robert D. Hof, The "Click Here" Economy, Bus. WK., June 22, 1998, at 122, 124.11. Bruce Ingersoll, Internet Helps Spur Growth, Cut Inflation, WALL ST. J., Apr. 16,

1998, at A3 (quoting Commerce Secretary William Daley).12. Peter Coy, You Ain't Seen Nothin' Yet: The Benefits to the Economy of E-commerce

Are Boundless, Bus. WK., June 22, 1998, at 130, 130.13. Id.14. Hof, supra note 10, at 126.

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ute their products. Traditionally, the purchase of goods by consumers in-volved either the consumer going to the merchant's local retail store andbuying the good or a representative of the company coming to the con-sumer's home. These geographical constraints were first weakened by theadvent of catalog shopping beginning one hundred years ago, which al-lowed consumers to order goods by mail from other locations.15 Directmarketing technologies, such as the use of toll-free numbers, computers,and faxes, have further reduced companies' needs for sales personnel orretail stores within states to sell to consumers there. With Internet Webpages increasingly replacing catalogs mailed to people's homes, the physi-cal connection between mail-order sellers and consumers is becoming evenweaker. 6 Today, with personal computers and modems, consumers haveinstantaneous, twenty-four-hour access to a full range of goods and serv-ices from all over the world without having to leave their home or office.

The type of goods that consumers purchase is also shifting from tan-gible to intangible goods and services. Increasingly, it is the packaging,and not the content, of the good that classifies it as tangible. For example,in purchasing a book you physically acquire a tangible item-the book'scover, binding, and pages. However, what you are really purchasing arethe contents of the book-the story contained in the words on those pages.As technology improves, there will be greater opportunities for purchasinggoods such as books, software, music, and videos electronically by down-loading over the Internet, which will allow the purchaser to acquire thecontent while avoiding the packaging altogether.

To illustrate the evolution of consumer purchases from traditionalphysical commerce to electronic commerce, assume that you wish to pur-chase a newspaper. Ten years ago, either you would go to a newsstand orstore to purchase the paper or a "paperboy" would come to your home todeliver the paper and collect what you owed. Today, you could order thenewspaper directly from the company over the phone or the Internet andhave it delivered to your home by a 'common carrier, such as the postalservice. Moreover, you could receive the newspaper in electronic form,either over the Internet or through electronic databases such as LEXIS orWestLaw. The newspaper is displayed on your computer screen ratherthan on'paper, thus eliminating the "packaging" altogether, along with theexpense and delay of shipping. As this example shows, the development of

15. Adams, supra note 5, at 497.16. Nathan Newman, Proposition 13 Meets the Internet: How State and 'Local Gov-

ernment Finances Are Becoming Roadkill on the Information Superhighway, 9 STATE TAXNOTES 927, 928 (1995) [hereinafter Newman, Proposition 13].

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electronic commerce has brought about a broader range of choices at po-tentially lower costs to consumers.

C. Lack of Fit Between Old Sales Tax System and New ElectronicCommerce

The three factors traditionally used in determining whether sales taxliability exists for a retail transaction present numerous problems in anelectronic commerce environment. First, regarding the content or sub-stance of the transaction, most taxing schemes impose a retail sales tax ontangible goods, yet more and more retail transactions involve intangiblegoods and services. Some intangible goods, like music, which are normallytransferred through a tangible medium, such as a compact disc, can now bedelivered through an electronic medium and avoid classification as a tan-gible good. As long as sales taxes are only imposed on tangible goods, thisshift in the type of goods being purchased results in an erosion of the salestax base and a subsequent reduction in sales tax revenues.

The second factor, situs, the location of the transaction, 7 is readilydeterminable in a traditional transaction where a consumer goes to a retailstore and purchases a tangible good-the taxing jurisdiction is the statewhere the vendor's store is located. However, if a resident of one statepurchases a tangible good from an on-line catalog on the Internet from avendor in another state, to be delivered to someone else in still anotherstate, then it becomes unclear in which state the transaction occurred. Oneof the distinguishing characteristics of doing business in cyberspace is thatthere are no geographic boundaries because events on the Net occur"everywhere, nowhere in particular, and only on the Net.' A physicalconcept such as situs does not adapt easily to a nonphysical environmentlike the Internet.

The concept of nexus 9 deals with whether the taxing jurisdiction hassufficient connection to the transaction to have the power to impose a salesor use tax on the transaction or collection duty on an out-of-state vendor."Since the buyer and seller need not have direct contact to engage in atransaction over the Internet, a nexus problem may develop if the buyerand seller reside in different jurisdictions.2' The nexus issue can also arise

17. BLACK'S LAW DICTIONARY 1387 (6th ed. 1990).18. David R. Johnson & David Post, Law and Borders-The Rise of Law in Cyber-

space, 48 STAN. L. REv. 1367, 1375 (1996).19. Nexus is defined as the sufficient presence of an entity with a state so as to appor-

tion the entity's taxable income to the state. BLACK'S LAW DICTIONARY, supra note 17, at1044.

20. Adams, supra note 5, at 502-03.21. Id.; See also Matthew N. Murray, Telecommunication Services and Electronic

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with regular mail-order sales, but the increase in on-line sales further exac-erbates the problem. States have the authority to impose a sales tax ongoods purchased within the state, regardless of who purchases the goods,or to impose a use tax on the purchases their residents make, regardless ofwhere they purchased the goods.' Even if the state has the authority to im-pose a sales or use tax on a transaction, it may not have the authority toimpose collection responsibility on the vendor.3

Traditionally, collection responsibility depended upon whether avendor had physical ties, or "substantial physical presence" in a state.24

Physical presence could be readily determined in an environment wheretransactions took place at a physical location or with sales representativesof the company within the state.2 But in an electronic commerce environ-ment, as with mail-order, vendors often do not have physical connectionswith the state, such as a warehouse or retail outlet, and may not even knowthe physical location of their customers when the customers make pur-chases via the Internet.

A major issue in the area of state taxation of electronic commerce isthe determination of which nexus standard to apply to Internet transac-tions. The nexus issue will be explored more fully in the subsequent dis-cussion of the Supreme Court opinion of Quill Corp. v. North Dakota,dealing with sales tax nexus in a mail-order context.27

II. CHALLENGES AND CONCERNS

A. Concerns of State and Local Taxing Authorities vs. Businessesand Consumers

While on-line and mail-order commerce has been growing, tradi-tional sources of state sales tax revenue have been dwindling.' States areconcerned that their current sources of sales tax revenue are being shifted

Commerce: Will Technology Break the Back of the Sales Tax?, 12 STATE TAx NOTES 272,274 (1997).

22. See discussion in Nathan Newman, The Great Internet Tax Drain, TECH. REV.,May-June 1996, at 24 [hereinafter Newman, Tax Drain].

23. Id.24. See discussion of physical presence infra Part IV.25. Jeanne Goulet, State Taxation of the Internet, Paper Presented at the Harvard

Spring 1997 Tax Symposium 9 (Apr. 5, 1997) (on file with the Federal CommunicationsLaw Journal).

26. Walter Hellerstein, State and Local Taxation of Electronic Commerce: Reflectionson the Emerging Issues, 52 U. MIAM L. REv. 691, 694 (1998) [hereinafter Hellerstein, Re-flections].

27. Quill Corp., 504 U.S. 298 (1992).28. Newman, Tax Drain, supra note 22, at 26.

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to an electronic environment where goods are less tangible, and locationsof sellers and buyers are often unidentifiable. 29 As a result, state and localsales tax revenue could plummet.

The United States Advisory Commission on Intergovernmental Rela-tions has estimated that "$3.3 billion in state and local sales taxes are...lost each year due to mail-order sales."30 This represents "approximately2.4 percent of total state sales tax collections." 3' While direct Internet salesare not very large (approximately $2 billion, or 20 percent of total Internetsales, in 1997),32 they are growing dramatically, and an on-line presencemakes it easier for companies to expand mail-order operations, resulting in

33an even greater erosion of sales tax revenue.Loss of this source of revenue could have a serious impact on a

state's financial position because "sales taxes generally yield more revenuefor state governments than any other tax.' ' 4 [Forty-four] states (and theDistrict of Columbia) now impose taxes on retail sales that account for anaverage of 25 percent of states' annual income.' ' 5

Businesses and consumers argue that the Internet has provided newopportunities for entrepreneurs and small businesses, and that the imposi-tion of sales tax liability on transactions over the Internet will serve as adisincentive to explore this new commerce venue and discourage new

36business. Businesses involved in electronic commerce are also concernedthat collection responsibility will be shifted their way, which could be amonumental administrative task.37 Some vendors argue that "[W]ith 46states, Washington, D.C., and more than 6,000 counties, cities, and schooldistricts collecting sales taxes (Delaware, Montana, New Hampshire, andOregon do not collect state or local sales taxes), the complexity of trackingtax rates in each area and dealing with local government authorities wouldoverwhelm most businesses."38

29. Adams, supra note 5, at 497-98.30. Newman, Proposition 13, supra note 16, at 927 (citation omitted).3 I. Id. at 929 (citation omitted).32. Hof, supra note 10, at 124-25 (quoting Forrester Research study that "[b]usiness-

to-business [electronic] commerce will account for 78% of the total spent on cyber transac-tions [in 1998]," and that business-to-business sales totaled approximately $8 billion in1997).

33. Newman, Proposition 13, supra note 16, at 928.34. Adams, supra note 5, at 498.35. Newman, Proposition 13, supra note 16, at 928.36. Dean F. Andal, Read My E-mail, No New Taxes, Paper Presented at the Harvard

Spring 1997 Tax Symposium i (Apr. 5, 1997) (on file with the Federal CommunicationsLaw Journal).

37. See Adams, supra note 5, at 500.38. Newman, Proposition 13, supra note 16, at 930 (citation omitted).

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B. Compliance Challenge

Tax compliance is also complicated in an electronic environment be-cause of the inability to observe electronic transactions.39 This is not an is-sue with on-line orders for physical goods since the purchaser provides aname and shipping address, although the sales tax on large-ticket itemsmay be high enough to provide an incentive to have the goods shipped to adifferent location to avoid imposition of a tax. The lack of an audit trailcan also be a concern with the purchase of non-physical goods, such asdownloading a software program.4 It can be difficult to identify the sourceor the destination of the transaction or determine the location of the taxableevent in a transaction that does not involve a physical good without the co-operation of the buyer. "While tax compliance has depended historicallyon identifying key taxing points, electronic commerce creates a challengefor the identification of such key points[,]" and such transactions may beprime candidates for tax avoidance.4

C. Collection Concerns

Once tax liability to a particular state is determined, the question re-mains as to who is responsible for collecting and reporting the tax due. In atraditional physical commerce transaction where a consumer goes to a re-tail store and purchases a good, the retail store is typically responsible forthe collection and reporting of the sales tax on the transaction.42 Since theretail store, as the middleman between the consumer and the producer, isthe location where the transaction takes place, it is responsible for collect-ing and remitting the sales tax to the state where the store is located.43

However, one of the characteristics of electronic and mail-ordercommerce is the change in the role of a middleman in consumer transac-tions. In electronic commerce, the middleman may not be used at all. Con-sumers can purchase directly from companies more easily than ever beforewithout having to go to a local intermediary to get the product, which re-moves the retailer as a means of collecting the sales tax. If a middleman isused, it is no longer used as a means to disseminate a company's productsto retailers, and ultimately to consumers, but as an intermediary to bringbuyers and sellers together.44 For example, a consumer looking for a par-ticular book can order it through Amazon.com, an on-line bookstore,

39. Murray, supra note 21, at 274.40. See Adams, supra note 5, at 499.41. Id. at 498-99.42. See generally HELLERSTEiN & HELETINw, supra note 1, ch. 19.43. Id.44. Hof, supra note 10, at 125.

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which will "shop" for the best bargain and have the book delivered to the45

consumer. The role of the new "cyberintermediaries" is to provide a con-venient service to consumers, rather than a distribution channel for sell-ers. 46

Since the traditional middleman role is disappearing, the issue forstates is to determine who or what will now serve this collection function.Although some argue that the Internet Service Provider (ISP) serves such amiddleman role, the ISP serves only as a medium for the exchange be-tween the vendor and the consumer.47 "Telecommunications service pro-viders are no more the vendor of goods and service delivered using theirservices than the express delivery company is the vendor of goods carriedto purchasers in its trucks." 8

If the ISP is not a middleman in the transaction, who will serve thecollection function for the taxing jurisdiction? One possibility for collec-tion is the Internet vendor, but in most cases, out-of-state vendors are pro-tected under the U.S. Constitution's Commerce Clause from state imposi-tion of sales or use tax collection responsibility if they do not meet a"physical presence" test.49 Another possible collection mechanism is forthe purchaser to directly submit a use tax, but since compliance is volun-tary and hard to track, enforcement would be difficult.

D. Need for Predictability

A major concern for all parties with an interest in the sales taxationof Internet transactions is the uncertainty surrounding the imposition andcollection of the tax.50 The unknowns of whether tax will be collected on atransaction, by whom and from where, "create enormous monetary risks"for "both taxing authorities and taxpayers."51 This lack of guidance andpredictability regarding the tax liability associated with transactions seri-ously hampers the development of electronic commerce. Before furtherprogress can reasonably be made in the development of electronic com-merce, all the players need to know the rules of the game.2

45. See Amazon.com (visited Nov. 8, 1998) <http://www.amazon.com>.46. Hof, supra note 10, at 125.47. Goulet, supra note 25, at 9.48. James R. Eads, Jr., Random Thoughts About a Possible Path, Paper Presented at the

Harvard Spring 1997 Tax Symposium 3-4 (Apr. 5, 1997) (on file with the Federal Commu-nications Law Journal).

49. Id. at 4. See also discussion of constitutional considerations infra Part IV.50. See Murray, supra note 21, at 275.51. See Adams, supra note 5, at 501.52. Murray, supra note 21, at 275.

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IV. SUPREME COURT GUIDANCE ON THE NEXUS ISSUE

A. Constitutional Issues

States are limited by both the Due Process and Commerce Clauses ofthe U.S. Constitution from imposing a tax liability or collection responsi-bility on a business unless there is substantial nexus, or in-state contact,established with the state.53 The degree of nexus sufficient to establishtaxing jurisdiction is a major issue in dealing with sales taxation of Inter-net transactions.

Presently, there is no statutory authority or case law addressing nexusmatters and the Internet for transactions involving the sale of goods.'M

There is, however, well-established case law pertaining to out-of-statesellers of tangible personal property that can provide at least some guid-ance in this area.5

B. Mail-Order Cases

Three Supreme Court cases dealing with the imposition of sales anduse tax on mail-order sales provide guidance on sales tax nexus standardsfor out-of-state vendors. First, in National Bellas Hess, Inc. v. Illinois De-partment of Revenue,56 the Supreme Court held that the state of Illinois wasrestricted from imposing a use tax collection duty on a Missouri-basedmail-order company for sales to Illinois customers. Bellas Hess had neitheroutlets nor sales representatives in Illinois, and its only contact with thestate was via mail or common carrier. The Court held that there was insuf-ficient contact to establish nexus under either the Due Process or theCommerce Clause and embraced a physical-presence nexus standard for

53. Walter Hellerstein, Supreme Court Says No State Use Tax Imposed on Mail-OrderSellers... for Now, 77 J. TAx'N 120, 120 (Aug. 1992) [hereinafter Hellerstein, SupremeCourt].

54. Bruce J. Reid, On the First Day, the Computer Gods Created Info. Serv. On theSecond Day, the Tax Collector Subscribed, Paper Presented at the Harvard Law School1997 Symposium 1 (Apr. 5, 1997) (on file with the Federal Communications Law Journal).There have been several recent cases involving nexus and the Internet in transactions otherthan the sale of goods over the Internet, but these areas are beyond the scope of this Note.See, e.g., Bensusan Restaurant Corp. v. King, 937 F. Supp. 295 (S.D.N.Y. 1996), aff'd, 126F.3d 25 (2d Cir. 1997) (involving trademark infringement and web advertising); Compus-erve, Inc. v. Patterson, 89 F.3d 1257 (6th Cir. 1996), reh'g denied, 514 U.S. 1035 (1996)(basing jurisdictional presence on telecommunications business activities); Oklahoma TaxComm'n v. Jefferson Lines, Inc., 514 U.S. 175 (1995) (imposing sales tax in state of pur-chase of bus ticket).

55. Reid, supra note 54, at 1.56. National Bellas Hess, Inc., 386 U.S. 753 (1967), overruled by Quill Corp. v. North

Dakota, 504 U.S. 298 (1992).

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both. 7 The Due Process Clause relates to the fairness of the tax burden andwhether a company has minimum contacts with the taxing jurisdiction.8

The concern under the Commerce Clause is the affect of state tax policy oninterstate commerce. 59

In Complete Auto Transit, Inc. v. Brady,60 the Supreme Court clarifiedthe four-prong test of the Commerce Clause: the state tax must be "appliedto an activity with substantial nexus with the taxing state, [must be] fairlyapportioned, [must] not discriminate against interstate commerce, and[must be] fairly related to the services provided by the State."6' AlthoughComplete Auto Transit clarified the nexus standards for the CommerceClause, it did not address the Due Process Clause.

In its 1992 decision in Quill Corp. v. North Dakota,62 the SupremeCourt revisited Bellas Hess and set forth guidelines for determining whatconstitutes sufficient in-state contact to establish taxing jurisdiction underboth the Due Process Clause and the Commerce Clause. The facts in Quillwere virtually identical to those of Bellas Hess: Quill was an Illinois-basedvendor with neither outlets nor sales representatives in North Dakota, andall of its contacts with the state were via mail, telephone, or common car-rier.63 Once again, the issue before the Court was whether such an out-of-state vendor had sufficient nexus with the state to support the state's impo-sition of a duty to collect a use tax on sales to residents of that state (in thiscase, North Dakota).

In Quill, the Court did not review the nexus standards under bothclauses together as it had in Bellas Hess, but instead considered the nexusquestion separately under each clause.64 Although Bellas Hess had sug-gested that physical presence was a due process requirement, the QuillCourt concluded that physical presence was not required for nexus underthe Due Process Clause. 65

The Court held that the only due process requirement is that the out-of-state vendor's efforts are "purposefully directed toward residents of an-other State," which for an out-of-state mail-order vendor would involve

57. Hellerstein, Supreme Court, supra note 53, at 120.58. Id.59. Id.60. Complete Auto Transit, Inc., 430 U.S. 274 (1977), reh'g denied, 430 U.S. 976

(1977).61. Id. at 279.62. Quill Corp., 504 U.S. 298 (1992).63. Id. at 302.64. Id. at 312.65. Id. at 312-13.66. Id. at 308 (quoting Burger King Corp. v. Rudzewicz, 471 U.S. 462, 476 (1985)).

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purposefully directing its solicitation toward residents of the taxing state.67

However, even though the Court did not impose a physical-presence stan-dard for due process, the physical-presence standard for the CommerceClause, which requires a more substantial nexus, was reaffirmed.68 So, al-though the Court held that the Due Process Clause did not bar the statefrom imposing a use tax collection duty on Quill, the Commerce Clausedid.

The physical-presence requirement for imposing a use tax collectionobligation on out-of-state sellers provides a large measure of protection forbusinesses. In the context of electronic merchants, it may be even moredifficult to establish nexus since contacts made via electronic commercemay be much less than for mail-order sellers. Under the guidelines thatexist from Quill, states will often be unable to require the vendor to collecttaxes on goods sold over the Internet.

However, the Supreme Court in Quill specifically invited Congress toact in the area of interstate sales pursuant to its power to regulate interstatecommerce under the dormant Commerce Clause.

By removing any due process objection to the imposition of use taxcollection obligations... and by resting the physical-presence rule en-tirely on the Commerce Clause, the Court left the ultimate decision asto state taxation of mail-order sellers in the hands of the LegislativeBranch. Because of Congress' plenary authority under the CommerceClause to broaden or restrict state taxing powers affecting interstatecommerce[,] ... Congress plainly may authorize the states to requiremail-order sellers to collect use taxes.

Although Congress has not chosen to pass such legislation, the sales taxissue should receive increasing attention along with other emerging elec-tronic commerce issues.

C. Similarities Between Mail-Order and Telephone-Order Salesand Internet Sales

In sales transactions involving physical goods, the purchase of aproduct over the Internet is essentially no different from a purchase bymail order or telephone order. The rules pertaining to mail-order and tele-phone-order sales should also apply to Internet sales. The real issue for thepurchase of physical goods becomes whether the current guidelines, asprovided in Quill, continue to be appropriate for out-of-state sales in lightof the dramatic change in the way consumers make purchases and thesheer volume of on-line transactions.

67. Quill Corp., 504 U.S. 298 (1992).68. Id. at 317.69. Hellerstein, Supreme Court, supra note 53, at 123-24 (citation omitted).

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Another concern in the electronic commerce area is the eliminationof "packaging. ' 70 As technology continues to improve, consumers will beable to obtain previously tangible goods in an intangible form by down-. 71

loading directly. Under the typical state sales tax scheme, intangibles are72not subject to sales tax. With a continued focus on physical presence as a

standard for the imposition of sales tax, as provided in Quill, fewer trans-actions will be subject to sales tax.

V. APPROACH TO A POSSIBLE SOLUTION

A. General Guiding Principles

In analyzing possible sales tax schemes for Internet transactions, thefollowing generally recognized tax policy principles should be used asguidelines.73

1. Economic Neutrality

Under the principle of tax neutrality, goods and services provided inelectronic commerce should be taxed no differently from goods or servicesprovided in conventional commerce.74 A "neutral sales tax would fall onthe final sale of goods.... regardless of the source of supply."75 Conse-quently, "'[i]ntangible products sold and delivered over the Internet shouldbe treated the same way for tax purposes as products purchased off-line inthe tangible world.' 76 For example, if states tax software purchased at aretail store but do not tax that software when it is purchased over the Inter-net, the state violates the principle that "a tax system should treat eco-nomically similar transactions the same. 77

70. Adams, supra note 5, at 497.71. The classification of intangible vs. tangible transactions in the context of interna-

tional income taxation has recently been addressed in Treas. Reg. § 1.861-18 (1998), deal-ing with sales or royalty income generated from foreign transactions involving the down-loading of computer programs.

72. HELLERSTEIN & HELLERSTEIN, supra note 1, 12.03, at 12-9.73. See generally Hellerstein, State Taxation: Preliminary Thoughts, supra note 7; Ad-

ams, supra note 5; and Murray, supra note 21.74. Hellerstein, State Taxation: Preliminary Thoughts, supra note 7, at 1315.75. Murray, supra note 21, at 273.76. Hellerstein, Reflections, supra note 26, at 697 (quoting Information Technology

Association of America (ITAA), Straight Talk: Internet, Tax & Electronic Commerce: AWhite Paper on Taxation of Electronic Commerce and the Internet 10 (undated and unpub-lished manuscript)).

77. See Hellerstein, Telecommunications, supra note 8, at 522.

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2. Uniformity

State sales taxes on electronic commerce should be uniform "'fromstate to state and from taxpayer to taxpayer."' 78 This does not mean that allstates need to use the same tax rate, but that uniform standards and defini-tions should be used in defining the sales tax base. Without a uniform taxsystem, a state where a seller is located could impose a tax and the homestate of the buyer could as well, resulting in double taxation. In addition,the lack of uniform standards could allow a direct seller to be in the posi-tion of collecting a sales tax if a product is ordered on its Web site, but notif it is purchased by phone. Uniformity should provide the same tax on agood regardless of the way the consumer buys it or from whom the con-sumer buys it.

3. Administrability

Another important objective is to minimize administrative costs andcompliance burdens for both taxpayers and tax administrators.79 "A seriouspractical complication for tax administrators is the lack of observability ofelectronic transactions, creating a practical obstacle to administration andenforcement.' ' 8 Since the transaction cannot be observed, it can be diffi-cult, and often impossible, to identify the parties in the transaction or theirlocation if they choose to remain anonymous.8 This translates into higheradministrative costs and heavy burdens on the retailers who would be re-sponsible for collection of the tax.

B. National Focus

Since the Internet effectively eliminates geographic borders, taxationof transactions over the Internet cannot be realistically bound by state bor-ders. Due to the importance of electronic commerce for the national econ-omy and the need for uniformity, the issue requires a national focus, ratherthan allowing each state to address the issue individually.

Several approaches for the development of uniform laws have beenproposed, including turning to traditional bodies that have written uniformlaws, such as the American Law Institute (ALI) or the National Conferenceof Commissioners of Uniform State Laws (NCCUSL), or providing a fo-rum for discussion through national tax associations, such as the Multistate

78. Hellerstein, State Taxation: Preliminary Thoughts, supra note 7, at 1315 (citationomitted).

79. Id. at 1316.80. Murray, supra note 21, at 274.81. Id.

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Tax Commission. 2 Federal legislation in the area of electronic commerceis also an alternative. In Quill, the Supreme Court invited Congress to actin the area of mail-order sales under its power to regulate interstate com-merce. 83 Since electronic commerce crosses (or ignores) state lines, it is anarea of interstate commerce where federal regulation is appropriate and de-sirable." Since the current guidelines provided by Quill protect the vendorfrom tax collection responsibility, congressional action is required if col-lection responsibility is to be placed on the seller.

Legislation was proposed, which President Clinton endorsed on Feb-ruary 26, 1998, imposing a moratorium on new taxes on Internet com-merce to allow time to study the issue. 5 Clinton noted that "the morato-rium does not prevent state and local governments from applying existingtaxes to electronic commerce, as long as there is no discrimination be-tween an Internet sale and a traditional one."86 Under this proposed bill,states could still collect taxes on sales of goods to buyers living in thesame state as the merchant, but not if the sales are made to buyers in otherstates-the same rules that apply to mall-order sales.7 The legislation waspassed by Congress in October 1998, imposing a three-year moratorium onnew state and local taxes on Internet commerce, and allowing for a com-mission to study the type of tax treatment that should be applied to the In-ternet.88

C. Redefining Nexus

The first issue that must be resolved in proposing a solution to thesales taxation of Internet transactions is the definition of nexus, or whatconstitutes "sufficient connection" with the transaction for a state to beable to tax the transaction. Since the traditional definition of nexus is tiedto physical location, it is totally inapplicable to electronic commerce. Theonly physical contact that an on-line vendor might have with a state couldbe the location of a server, which has nothing to do with the economic sub-stance of the transaction, and could be easily moved to another location toavoid taxation.89

82. Adams, supra note 5, at 506.83. See Quill Corp. v. North Dakota, 504 U.S. 298, 318 (1992), cert. denied, 510 U.S.

859 (1993).84. See Adams, supra note 5, at 506.85. Tom Raum, Clinton Backs Ban on New Internet Taxes, Offers New Disaster Aid,

THE AsSOCIATED PRESS, Feb. 26, 1998.86. Id.87. Id.88. Tax Moratorium, CQ WKLY., Oct. 17, 1998, at 2818.89. See Hellerstein, State Taxation: Preliminary Thoughts, supra note 7, at 1318; Ad-

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Professor Walter Hellerstein of the University of Georgia, a well-recognized expert in the sales and use tax area, suggests one possibility forredefining nexus as "the establishment of nexus over the out-of-state ven-dor in the state of the purchaser."94 Congress could require on-line vendorsto collect and remit sales/use tax to the state of the purchaser. The state ofthe purchaser could be based on locational information provided to thevendor by the purchaser, such as the billing address or shipping address.9

The concern that on-line vendors express about the burden and complexityof such a responsibility is without merit. Basic spreadsheet programs(Excel, Lotus) could easily be developed to calculate the sales tax for alarge number of jurisdictions based on the rate of the relevant taxing juris-diction.

Another alternative to having the on-line vendor collect the taxes isto have states directly tax consumers through a use tax, placing the burdenof reporting and remitting on the consumer.92 States have the authority totax their residents, regardless of where or how the residents buy theirgoods.93 Use taxes, however, are hard to collect. Since use taxes are self-assessed, they require taxpayers to maintain records of their purchases, andreporting is basically done on an honor system.

There are several advantages to a system of taxing transactions basedon the location of the purchaser and imposing collection responsibility onthe on-line vendor. One is that it is relatively simple and easy to under-stand for all parties involved: consumers, vendors and state and local gov-ernments.' The vendor is also the most logical party to collect the taxsince it has access to the relevant information about the transaction. Hav-ing the on-line vendor collect the tax and remit it to the appropriate statealso helps maximize sales tax revenue for states because it provides stateswith a mechanism for taxing transactions that they would otherwise have adifficult time capturing. 95

One of the weaknesses of such a system is the difficulty for the ven-dor of obtaining locational information without the cooperation of the pur-chaser since one of the characteristics of the Internet is that the vendormay not know the location, or even the identity, of the party with whom he

ams, supra note 5, at 508.90. Hellerstein, State Taxation: Preliminary Thoughts, supra note 7, at 1318.91. Id.92. A solution involving "enforcement of existing use tax laws on consumers based on

information furnished by sellers" was suggested by James Eads, Jr., Random ThoughtsAbout a Possible Path, supra note 48, at 10.

93. Hellerstein, State Taxation: Preliminary Thoughts, supra note 7, at 1319.94. Id.95. Id.

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is dealing.96 For all practical purposes, however, the "anonymous pur-chaser" is by far the exception in Internet transactions. Locational infor-mation generally must be provided for delivery, in the case of tangiblegoods, or for billing purposes, since at least currently such transactionsmust be paid for with a credit card. Although a purchaser could avoidtaxation by having an item shipped to a fictitious address in a state withouta sales tax, this risk of tax avoidance already exists with mail-order sales,and in most cases, the potential tax savings would not be worth the troubleto the taxpayer.

VI. CONCLUSION

Electronic commerce is experiencing rapid growth, and this explosivegrowth is expected to continue. The economic reality is that the means bywhich consumers are purchasing goods and services, and the types ofgoods and services they are purchasing, are changing dramatically and willcontinue to change. Physical presence, the current standard for establishingnexus in the sales and use tax context, is no longer an appropriate measureof a state's connection to a transaction. Without the ability to impose a taxon these transactions, states will no longer be able to rely on sales tax as asource of revenue.

Reevaluation of the overall sales and use tax structure requires look-ing at all consumer transactions, including mall-order and telephone-ordersales, and not just Internet transactions. New standards for defining whenand how a state or local taxing jurisdiction may tax a transaction must bedeveloped. Transactions are no longer bound by state geographic bounda-ries; therefore, any system for taxing these transactions requires a national,rather than a state or local approach. The Supreme Court's invitation toCongress in Quill to act in the area of interstate mail-order sales under itspower to regulate interstate commerce also applies in the area of electroniccommerce.

In developing new guidelines, whether through federal legislation oruniform state laws, there must be uniformity. The sales and use tax systemshould impose taxes uniformly on goods and services, regardless of howand from whom they are purchased. If a product is subject to tax, then thattax should be imposed regardless of whether it is purchased in a store, overthe telephone, through the mail, or over the Internet.

96. Id.

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